The Task Force on Climate Related Financial Disclosures issued its final report last week after looking at the issue of climate risk in the financial system. Comprised of private sector finance and industry leaders, the Task Force recommends that companies and financial institutions of all types adopt common climate-related financial disclosure practices as a way to support informed and efficient capital allocation decisions. Disclosure of climate-related risks falls primarily into two categories: first, the risks arising from the necessary transition to a low-carbon economy and the possible shocks that might occur from moving out of fossil-based energy systems and into cleaner and more efficient energy systems; and, second, the risks arising from physical changes expected to occur as the planet warms.
These risks impact a business’s and investor’s financial health in a variety of obvious and not-so-obvious ways. For example, earlier this month several airplanes were grounded in Phoenix because of excessive heat, which affects their ability to safely take off. American Airlines subsequently cancelled more than 50 flights, mostly because many of the planes they were flying out of Phoenix were not cleared to fly at temperatures over about 120 degrees. It is normal for airlines to plan for weather-related disruptions to business. For American, bearing the consequences of that heat-related disruption may be manageable, but at some point, the frequency or duration (or both) of excessive heat events may require management to consider whether mitigation tools, such as business interruption insurance, actually offset the potential costs. Or, perhaps consider purchasing new planes that are more resilient to the expected excessive conditions in Phoenix. For investors, understanding whether these risks are small or large; static, diminishing or growing; and how American might manage such climate-related risks, is important. Providing a framework for disclosing these types of risks is an essential step in surfacing financial impacts to investors.
In the example above, climate-related concerns impact not only the business of airlines, but also the airport infrastructure itself. This can lead to questions about runway length and siting, both of which are impacted by changing climate. Whether in transport, energy, water or other sectors, one of the more obvious applications both for new tools for assessing climate risk, and greater disclosure to investors, is new infrastructure investment.
According to the Brookings Institution, more infrastructure investment will be made in the next 15 years (globally) than the entire stock of infrastructure that currently exists. In the United States, this year’s Infrastructure Report Card from the American Society of Civil Engineers grades existing infrastructure as a D+. This implies potential for a significant pipeline of investments in infrastructure (both big and small) in the coming years, and banks are looking for this type of pipeline. In fact, sustainable infrastructure is a key focus for many development finance institutions, from the Inter-American Development Bank to the Asian Infrastructure Investment Bank.
Regardless of sector, investing in infrastructure can often be complex and time-consuming, involving sometimes dozens of financial institutions and different types of investors. Banks and specifically those that finance infrastructure will have an important role to play in how “resilient” and “sustainable” new investments are to a warming planet.
While the significant need for new infrastructure implies a potentially promising pipeline, will this pipeline of infrastructure projects be “bankable”? And, perhaps more importantly, how “bankable” is an infrastructure project if it isn’t climate resilient?
What Is “Bankable” Anyway?
Many things can impact a project’s “bankability”, including unfavorable regulations and policies, high transaction costs, and lack of viable funding and business models. “Bankability” implies a notion that the risk-adjusted returns of a project are balanced in such a way that lenders and investors believe the risk exposure does not outweigh the return potential. Inadequate risk-adjusted returns impact a project’s “bankability”. The catalogue of risks that is often considered includes specific risks embedded in the business, such as technology risks, management risks, and risks to the ability to sell products and capture market share. Risks also exist outside of the business’s direct control that impact a project’s “bankability”, such as foreign exchange risk, political risks, and regulatory and legal risks.
The decision to invest in a project involves assessing the entire catalogue of a project’s risks weighed against its potential returns. Often, this appraisal incorporates the real risks present in a project, a lender’s perception of risks, and ways the project’s sponsor or the business proposes to mitigate those risks (sometimes by doing things differently, sometimes by buying insurance products). If the risk-adjusted pricing is just right, the project is “bankable”. If the risks outweigh the potential returns, it simply is not.
While many investors look at a range of risks in similar ways, few today look at the impacts that climate change might have on a project’s revenues, costs, or assets, and more specifically how climate change might impact a project’s business model.
Without a Measure of (Climate) Risk, Is a Project “Bankable”?
Is a project “bankable” if it isn’t climate-resilient, or hasn’t incorporated a measure of climate risk? We would argue that climate-risk should be an element of project or business’s overall risk profile, and can no longer be ignored by investors.
Following the momentum generated by the Task Force, the significant need for infrastructure investment worldwide, and the groundswell of interest by many financial institutions seeking to invest in sustainable infrastructure, the time may be right to develop the metrics, methodologies and approaches to integrate climate-risk into investment decision making.
We have argued that more needs to be done to give bankers and investors the tools they need to assess climate risks at the investment decision stage to exactly understand whether these risks are small or large; static, diminishing or growing, and what the impact of climate-related hazards, such as water stress or heat will be to a business’s or project’s revenues, assets and costs over meaningful time horizons. These “tools” will be critically important, both for managing existing risks in a portfolio and for making better decisions for new investments.
Common approaches, metrics and methodologies for assessing climate risks which are actively applied and become mainstreamed by banks will support better investment decision making, particularly in infrastructure. This, in turn, will allow for more thorough climate-risk disclosure for all types of investors, which itself has the potential to spur greater investment by larger numbers of investors in sustainable – and more climate resilient – infrastructure.